Mapping the slowdown of China’s economy

For the past few months, there has been an expectation among many economists that China’s economy would soon decelerate sharply. Now there is evidence that this process has begun. China’s economy grew quite slowly in the fourth quarter of 2021, although not as slow as some investors evidently anticipated. Meanwhile, retail sales barely grew at all in December and investment in property fell sharply. The latter is evidence that troubles in the property sector are starting to have real consequences. These negative factors were partly offset by stronger than expected industrial production in December. Let’s take a look at the details:

Chinese monetary policy addresses slow growth

In the United States, Canada, United Kingdom, and the eurozone, central banks are tightening monetary policy due to high inflation and accelerating economic growth. In China, however, economic growth is decelerating while inflation remains low. Hence, it is not surprising that the People’s Bank of China (PBOC) has been easing monetary policy. In fact, last week it cut a key interest rate, the one-year prime loan rate, for the second consecutive month. In addition, it cut the five-year prime loan rate for the first time since April 2020. This comes on top of recent reductions on the required reserve ratio (RRR) for commercial banks. Moreover, many observers expect that the PBOC will take further steps to ease credit conditions in the months ahead. 

All these changes are meant to encourage more credit creation at a time when some segments of the Chinese economy are contracting—especially the residential property sector. The relatively low 4.0% growth of real GDP in the fourth quarter revealed the extent of the damage to China’s economy from the property crisis. Moreover, the government will be keen to avoid a financial crisis that could stem from the problems faced by property developers in servicing large debts.  Several property developers have defaulted on obligations and construction activity has declined. The government wants to keep credit lines open, and especially wants to encourage continued mortgage lending so as to avoid a property sector meltdown. In response to the latest actions, Chinese equity prices increased sharply, led by property developers.

China’s long-term demographic problem worsens

In 2021, China’s population increased by less than 500,000 people from the previous year, out of a population of 1.4 billion. To look at it another way, the population grew at a rate of 0.034%. This was the smallest rate of increase in 60 years. It reflected a stunning decline in births, a trend that began in 2017. That, in turn, reflects people marrying later and choosing to have fewer children. For example, in the first nine months of 2021, there were 17.5% fewer weddings than in the first nine months of 2019. 

Some demographers now predict an absolute decline in China’s population starting as early as 2022. Others suggest that the population will peak in 2025. Either way, this means that China’s demographic time bomb could detonate much sooner than previously anticipated.  In other words, there will be a sharp decline in the number of workers at the same time as continuing growth in the number of retirees. Moreover, the number of retirees will likely accelerate soon once the generation born after 1962 starts to retire. That year was the start of a ‘baby boom.’ 

A declining ratio of workers to retirees is a problem faced by many countries today, especially the neighboring Japan. Yet most of the other countries are advanced economies, not emerging economies like China. This shift in demographics means greater stress on pension and healthcare systems while, at the same time, the paucity of workers means slower economic growth absent a significant acceleration in productivity growth. The shortage of labor means higher labor costs, making China a less attractive investment location absent higher productivity.   

Also, the decline in the population will mean that it will take longer for China’s GDP to surpass that of the United States. However, the vice foreign minister said that “exceeding the US in GDP, we are not interested in it, and this is not what we are going after.  To meet the people’s desire for a better life, this is what the Communist Party of China aims for.” 

China’s leaders are, however, concerned about the slow population growth and have taken steps to boost births as well as labor force participation. The much heralded one-child policy was ended in 2016 and there is now a three-child policy in urban areas. The government intends to provide financial incentives for parents. In addition, the latest proposed five-year plan calls for the retirement age to be increased from 60 to 65 for men and from 55 to 60 for women, thereby boosting the size of the labor force. One method of addressing population decline and demographic change is to allow more immigration.  However, this does not appear to be one of the government’s options at the moment. 

On the positive side, China continues to become more urban. The urban share of the population continues to grow at a good pace. Given that urban workers tend to be more productive than rural workers, this boosts productivity. In addition, the likely shortage of labor and the concomitant boost to wages will likely create an incentive for businesses to invest in labor-saving and labor-augmenting technologies, thereby boosting productivity.  The higher wages of workers will help to boost consumer spending as a share of GDP, which is one of the government’s goals.

Japan’s central bank commits to retaining an easy monetary policy

Japan has lately seen an increase in inflation and an increase in long-term borrowing costs.  Still, yields remain historically low while inflation remains far below that seen in most other advanced economies. Thus, it is not surprising that the Governor of the Bank of Japan, Haruhiko Kuroda, said: “We will keep our monetary policy loose until after consumer inflation stably exceeds 2%. We are not thinking about changing our easy monetary policy or having any such discussion.” The very easy monetary policy of the BOJ, which has been a constant for many years, has lately contributed to a sharp decline in the value of the yen.  At 116 yen per dollar, the currency is at the lowest value in about five years. This, in turn, boosts the competitiveness of Japan’s exports and contributes to inflation by boosting import prices. 

While consumer price inflation in Japan remains low, with prices up only 0.8% in December versus a year earlier and core prices up only 0.5%, producer price inflation has been substantial. Producer prices were up 8.5% in December from a year earlier, reflecting the impact of a sharp rise in commodity prices, including oil prices.  Governor Kuroda, however, said that he sees the commodity price increases as temporary and, consequently, not likely to fuel ruinous levels of consumer price inflation. He said: “We do not intend to tighten our monetary policy in response to temporary price increases. Our goal is to bring about broad-based price increases by realizing a positive cycle of higher wages.” So far, this has not happened. 

Meanwhile, some analysts believe that Japan could soon achieve the 2.0% inflation that has been the elusive goal of the BOJ for several years. Yet it might be short-lived. The BOJ remains keen to boost inflation and avoid hurting growth by changing monetary policy.  This is especially important at a time when economic growth in Japan is finally picking up speed. Indeed, it was reported that, in November, industrial production increased 7.0% from the previous month, the strongest month-to-month growth on record.  

Global bond market trends

Yields on long-term government bonds have increased sharply in recent weeks in the United States, Canada, United Kingdom, and eurozone.  In the United States, the yield on the 10-year government bond hit 1.85% on Tuesday, January 25, 2022, the highest level since January 2020—just prior to the pandemic. Interestingly, this is not a reflection of rising expectations of inflation. Indeed, the so-called breakeven rate, which is the component of bond yields attributable to expectations of inflation, remains steady. Rather, the rise in yields reflects an increase in the real (inflation-adjusted) yield which is a measure of the impact of supply and demand conditions in the bond market. This is true not only in the United States, but in Canada and Europe as well. 

Notably, the real yield on the US 10-year bond remains negative. The nominal yield in Germany is negative. Yet these yields are not as negative as they were a few weeks ago.  The increase in real yields is likely due to several factors. These include expectations that the omicron variant will be less disruptive than initially anticipated; expectations that economic growth will be strong in the coming year; expectations that central banks will taper bond purchases faster than previously anticipated; and expectations that central banks might soon dispose of the bonds they have purchased. 

Also, it is worth noting that, although bond yields are up sharply, they remain historically low. Why? There are several possible explanations. First, investors expect long-term inflation to remain low. Second, they expect government borrowing to decline sharply after a major spate of borrowing during the pandemic. The US fiscal deficit as a share of GDP is expected to decline this year by the largest amount since the end of World War II. Finally, investors have probably noted the massive pool of savings accumulated by consumers and businesses during the pandemic. This makes it easier to fund future government borrowing, thereby suppressing yields. 

Has the supply chain crisis turned the corner?

• Economists and business leaders are eagerly looking and hoping for evidence that the supply chain disruption of the past year is abating. Fortunately, there is such evidence, although we are not yet out of the woods. For example, Taiwan’s government reports that overall exports to the mainland increased dramatically in 2021, largely due to a surge in exports of semiconductors. Specifically, Taiwanese exports were up 24.8% from 2020 to 2021. Exports to the mainland were up 22.9%. Also, Taiwanese exports of electronic components to the mainland were up 23.3%.  

This massive growth indicates several things. First, China’s own production of semiconductors has not kept pace with demand, especially due to US sanctions that limited Chinese access to certain technologies. Hence, strong demand for Taiwanese electronics. Second, it indicates strong Chinese manufacturing activity, which depends heavily on semiconductors. Indeed, Chinese exports grew rapidly in 2021. Third, it indicates that production of semiconductors is increasing rapidly, suggesting that the shortage is diminishing. Indeed, Taiwan’s government reported that manufacturing capacity has increased considerably in the past year. 

Taiwan remains the world’s most important producer of semiconductors, estimated to account for 64% of global output. Yet, Taiwanese companies are evidently keen on diversifying risk. As such, they continue to invest overseas. However, investment into the mainland declined 14.5% last year (while mainland company investment in Taiwan declined 62.9%). Meanwhile, Taiwanese investment in Southeast Asia, Australia, and New Zealand increased 115.6% last year.

There is other evidence of supply chain improvement. There has been a sizable decline in the cost of shipping commodities and containers, as evidenced by a decline in the well-known Baltic Dry Index as well as the Harper Index. This means that the bottlenecks of the past year are starting to diminish. In addition, there has been a drop in the prices of several mineral and agricultural commodities. This means that shortages of these inputs are starting to abate. And finally, there has been a sizable increase in industrial production and manufactured exports in East Asia. This suggests that manufacturers are increasingly able to meet the strong demand that led to disruption in the first place. 

Also, there is reason to expect that global demand for manufactured goods will decelerate in the year ahead. Already, we have seen a decline in real (inflation-adjusted) spending on goods by US consumers over the past half year. Although the level of spending remains well above prepandemic levels, it’s declining from the peak reached in early 2021. This likely reflects an easing of government stimulus, satisfaction of pent-up demand, and possibly a consumer decision to shift back toward spending on services. Going forward, most advanced economies are expected to experience a tightening of monetary and fiscal policy in the coming year, with the likely result being weaker growth of consumer demand. Less consumer demand for goods will mean fewer bottlenecks and less stress on supply chains. It could also mean less inflation. 

Still, one might ask what could possibly go wrong? The principal answer is that the virus still retains the power to disrupt or interrupt recovery of supply chains. The current lockdown in Xian, a large city in China, is indicative of what can happen and what impact it might have on global manufacturing. In addition, if consumers are forced to avoid consumer-facing services, it may prolong their choice to spend heavily on goods. The conventional wisdom right now is that omicron, as bad as it is, will quickly go away within the next month. This may or may not be true. Moreover, even if true, it does not preclude further variant outbreaks.

Another problem is the so-called bullwhip effect—that is, individual companies attempting to avert problems by hoarding key inputs and commodities. For an individual company, this strategy can be helpful. Yet, when every company does this, it exacerbates shortages, reduces supply chain efficiency, and prolongs inflationary pressures. It is not yet clear if the bullwhip effect is abating.

Yet another problem involves my home city of Los Angeles. Everything in the world could go smoothly, but if the neighboring ports of Los Angeles and Long Beach (which account for 40% of all goods entering the United States) fail to address their obstacles to capacity and efficiency, the whole system could remain disrupted. The Biden Administration has called for a shift toward 24-hour operations, but labor negotiations could get in the way of boosting capacity. 

Finally, much will depend on what happens in China. The current zero-tolerance policy, in which factories or ports can be temporarily shut down in response to minor outbreaks, is inimical to supply chain efficiency. If the policy persists, especially in March after the Winter Olympics, it will stymie supply chain recovery. If, on the other hand, China eases the policy, it could help to restore efficiency to supply chains.  

• While there is anecdotal evidence that the corner might have turned, it would be helpful to have more precise quantitative evidence, one way or the other. Economists at the Federal Reserve Bank of New York (FRBNY) have come up with an index—the Global Supply Chain Pressure Index (GSCPI)—designed to signal the direction and degree of stress in global supply chains. There are 27 different variables in the index. These include three supply chain indicators (delivery times, backlogs, and purchased inventories for manufacturers) for each of seven major countries. These indicators are adjusted to account for changes in demand. In addition, the GSCPI includes three measures of transportation costs: one for shipping commodities, one for shipping containers, and one for air freight costs. 

During the pandemic, the GSCPI has increased to an unprecedented level, indicative of the unusual nature of the pandemic. The last time the index increased significantly was in 2011. That was due to stress created by the Tohoku Earthquake in Japan as well as a major flood in Thailand, both of which disrupted automotive supply chains. During the pandemic, the index first increased dramatically in early 2020, then fell dramatically as economies reopened. It then increased dramatically again in 2021 as global demand rebounded while supply-side disruption continued. Notably, the authors of the index note that, “more recently, the GSCPI seems to suggest that global supply chain pressures, while still historically high, have peaked and might start to moderate somewhat going forward.”

Has US inflation peaked?

• Last week, US Federal Reserve Chairman Powell said that high inflation is a “severe threat” to the economic recovery in the United States. He added that “to get the very strong labor market we want with high participation it is going to take a long expansion. [And] to get a long expansion, we are going to need price stability.” Furthermore, in light of the absence of price stability at the moment, Powell said, “I would expect this year, 2022, will be a year where we take steps towards normalization.” Powell also said that the process of reducing monetary stimulus will take place sooner and faster than previously anticipated. 

The question now is whether Powell’s change of tune comes too late. Some critics will argue that he should have started tightening policy once inflation began to rear its ugly head in mid-2021. They might say that inflation is already out of control and will now require more onerous measures to achieve a reversal. Yet, Powell long maintained, and still does, that the inflation would be temporary and that it will likely recede once supply chain difficulties ease. Moreover, there are some early indications that supply chain problems are starting to abate. Still, inflation has lasted longer and been more onerous than he initially anticipated. 

It is likely that Powell’s remarks were meant, in part, to provide a useful signal to investors and businesses. That is, he wants them to know that the Fed will take strong steps to limit inflation. In so doing, he is attempting to anchor expectations in order undermine an inflationary psychology. Such a perception could lead to changes in behavior that would exacerbate inflation. His efforts appear to be successful in that measured expectations of longer-term inflation remain muted—at least for now.

Meanwhile, the US government last week released data on December inflation.  Investors expected annual inflation to hit 7%. It did. Consequently, investors were not surprised. Bond yields fell slightly. Although inflation is high, the report did offer a mixed picture concerning the intensity of inflation. Let’s look at the details.

First, consumer prices were up 7% in December versus a year earlier, a nearly 40-year high. Prices were up 0.5% from the previous month. However, when volatile food and energy prices are excluded, core prices were up 5.5% from a year earlier and up 0.6% from the previous month. There was an especially high annual increase in energy prices, up 29.3%. Yet, energy prices fell 0.4% from the previous month. There was also a big increase in the prices of used cars, up 37.3% from a year earlier and up 3.5% from the previous month. The price of shelter also increased strongly, reflecting a gradual increase in rents and imputed rents in line with rising home prices. In addition, the price of hotel rooms increased very strongly. 

Notably, the preponderance of inflation was in goods rather than services. The price of durable goods was up 16.8% from a year earlier and the price of nondurable goods was up 10.2%. On the other hand, the price of services was up 4% and the price of nonenergy services was up 3.7%. Airline tickets were up only 1.5%. This unusual pattern has been a hallmark of the surge in inflation in the past year. It likely reflects the huge impact of supply chain disruption. It also suggests that if supply chain disruption abates, inflation will revert to a lower level. That is the expectation of the Fed as well as many investors. 

Meanwhile, inflation is threatening the economic recovery given that real (inflation-adjusted) wages are mostly declining. This reduces the actual purchasing power of consumers at a time when fiscal stimulus is being withdrawn. Moreover, tightening monetary policy also threatens to boost borrowing costs for consumers and businesses.  Thus, reducing inflation soon will be critically important to a sustained recovery. The best hope is that supply chain problems will abate and that energy prices will stabilize or decline. At the least, both fiscal and monetary policy are now on a path that will not exacerbate inflation.

Emerging nations face a challenging postpandemic situation

• The World Bank published its revised economic forecasts for 2022 and beyond. It noted that emerging and developing nations are especially at risk of falling behind: “By 2023, all advanced economies will have achieved a full output recovery; yet output in emerging and developing economies will remain 4 percent below its pre-pandemic trend. For many vulnerable economies, the setback is even larger.” 

The challenge for emerging nations is threefold. First, most of these countries lack sufficient policy flexibility to address obstacles. They face higher inflation than advanced economies, thereby constraining monetary policy. In addition, many are already severely indebted, thereby stifling fiscal space. The second challenge is that the advanced nations, which purchase goods and services from emerging nations, are likely to see a significant slowdown in growth this year. The World Bank forecasts that the United States, Eurozone, and China, the three largest economies in the world, will grow more slowly in 2022 than in 2021. The third challenge is that emerging nations are far behind the advanced nations in vaccinating their people. This leaves these countries far more vulnerable to current and future variants of the virus. Outbreaks can disrupt both supply and demand, thereby slowing economic growth and creating significant public health challenges. 

Meanwhile, the World Bank drew attention to the fact that a variety of indicators for emerging markets have worsened during the two-year pandemic. These include income inequality, gender inequality, life expectancy, access to health care, and educational attainment. The scars from the pandemic are likely to be deeper and more prolonged than in advanced economies. Weak economic outcomes could also exacerbate social and political tensions, thereby leading to increased risk of instability and violence.

Why have bond yields surged recently?

• In recent weeks, there has been a sharp increase in bond yields in the United States, the United Kingdom, Germany, France, Italy, Spain, Japan, Australia, and other advanced economies. Investors evidently do not expect the omicron variant to significantly disrupt the strong global economy. Rather, they expect strong economic growth combined with central banks withdrawing the purchases of bonds. The US Federal Reserve, the Bank of England, the European Central Bank, and the Bank of Japan have signaled an intention to reduce or end bond purchases in the coming year. Investors also expect central banks to boost short-term interest rates in the coming year. Bond yields are, in part, a forecast of future short-term rates. Although investors still expect inflation to decelerate later this year (as evidenced by relatively stable breakeven rates), they have driven up bond yields due to expectations of growth and changing supply/demand conditions in the bond market. As such, rising bond yields are a signal of economic health. On the other hand, unless inflation expectations change significantly (which could happen), it seems unlikely that bond yields will rise precipitously going forward. 

Still, the question arises as to why bond yields increased so suddenly and dramatically in the last few weeks. The answer is that yields had been somewhat suppressed following news in November that the omicron variant was a threat to public health. But by the beginning of 2022, conventional wisdom was shifting toward a view that omicron would not be hugely disruptive to the global economy and that any disruption was likely to be short-lived. In other words, there was reason to expect a quick resumption of strong growth once omicron fades. Moreover, there were increasing signals from central banks that a shift in policy was coming—especially after the release of the Federal Reserve’s latest minutes on January 5. This shift will likely involve fewer central bank purchases of government bonds.

Omicron’s disruptive surge

The holiday break was most welcome. However, as millions of us returned to work in early January, we also returned to a new reality. During the intervening time, the pandemic returned with a vengeance. The new omicron variant, which is highly contagious, has caused a dramatic increase in infections in Europe and North America, with a strong likelihood that the infection rate will rise much higher in North America in the next few weeks. Although most governments have not imposed significant restrictions on activity and mobility, there is reason to expect that omicron could have negative economic consequences. With many people getting infected, including those who are vaccinated or who have been boosted, the number of people not reporting to work has increased sharply, especially in critically important industries such as health care and transportation. If this trend continues, it could limit economic activity and disrupt vital supply chains. Here is what we know so far:

• In the United States, the seven-day average daily infection level increased from 497 per million on December 22 to 1,809 per million on January 6. Hospitalizations have increased sharply as well, largely due to unvaccinated people getting infected. Hospital admissions increased from 58,000 on December 22 to 128,000 on January 6. In addition, the number of children being hospitalized has soared. Meanwhile, the high rate of infection and sickness has led many people to stay at home rather than work. The result has been a shortage of workers at hospitals, airlines and airports, and other venues. In New York, for example, several subway lines have been suspended. Many flights have been cancelled. Some cities face a shortage of public safety workers. Many businesses are cancelling in-person events. And many schools are shifting, at least temporarily, to online learning. 

Going forward, many experts believe the infection rate will increase sharply in the first few weeks of January before receding. The number of hospital admissions is likely to increase commensurately, creating a challenging situation given the shortage of health care workers. The problem is largely the high number of unvaccinated people. Only 62% of the US population is fully vaccinated. Moreover, the vaccine wears off over time, necessitating booster shots. Yet only about a third of the vaccinated (20% of the total population) have received boosters. Meanwhile, many vaccinated people are getting infected but not becoming ill. Still, they must quarantine as they can transmit the virus to others. 

• In much of Europe, the infection rate has soared far above that of the United States. For example, the daily infection rate increased from 1,338 per million on December 22 to 2,664 per million on January 6 in the United Kingdom. In France, it increased from 842 to 3,059. In Italy, it increased from 450 to 2,352. And in Ireland, it increased from 1,048 to 4,020. Yet the hospitalization rate in most European countries is well below that of the United States. The reason is that, with a much higher rate of vaccination, many European countries are seeing a relatively high number of breakthrough infections in which vaccinated people become infected but do not become sick. Still, those with breakthrough infections are contagious and are a danger to vulnerable populations. That is why quarantine becomes necessary and people wind up avoiding work. Thus, while Europe is unlikely to face as severe a public health crisis as the United States, it could still face an economic problem if many people fail to work. Moreover, fear of the virus will likely reduce consumer mobility and, therefore, spending. 
• Notably, the omicron variant has not yet had a big impact in some other important parts of the world. In Germany, the infection rate has been declining in the past few weeks. In Japan, the infection rate, although on a rise, is trivially low. In the four BRIC nations (Brazil, Russia, India, China), the infection rate remains low, although it has started to rise in India.  

Still, the threat of omicron has led governments to take steps meant to stifle transmission that could have negative economic consequences. In China, the zero-tolerance policy has led to lockdowns in some large cities such as Xian. In India, experts fear another surge, especially given the large number of mass gatherings related to upcoming elections. India already went through a devastating surge in infections in the year that just ended. The economy has lately been recovering. The new global outbreak represents a significant economic and public health risk. Likewise, Japan is preparing for a surge, maintaining strict border controls and setting aside hospital beds as a contingency. 

• The bottom line is that the global economy is likely to see a deceleration in activity this month. A slowdown in spending could cause a reduction in commodity prices and a decline in inflation. On the other hand, to the extent that vital industries are disrupted by pandemic-related labor shortages or government-imposed restrictions, supply chain disruption could worsen and be prolonged, thereby contributing to higher inflation. As for policymakers, major central banks have already begun to ease monetary stimulus on the view that economies are strong and can face inflation risk. A new slowdown in economic activity could lead central banks to reconsider their options, although there is no evidence that this has happened. 

Once omicron has run its course, recent trends are likely to return. These include decelerating consumer spending on goods as well as improvements in supply chain efficiency and activity. Combined, these factors are likely to help reduce current inflationary pressures.   

Federal Reserve minutes shake markets

• The Federal Reserve’s policy committee last met on December 15. At that time, it announced that the tapering of asset purchases would be accelerated. It indicated a likelihood of multiple increases in the benchmark interest rate in 2022. Investors accepted this news with alacrity. However, the details of the members’ deliberations were not known until last week when the Fed released the minutes of the December 15 meeting. The release of the minutes, it turned out, was more impactful than the meeting itself. Yesterday, bond yields increased while equity prices fell sharply in response to the new information. Why? 

The answer is that the Fed’s internal deliberations suggested the possibility of a more sweeping tightening of monetary policy than the public statement on December 15 indicated. Specifically, the minutes stated that “it may become warranted to increase the federal funds rate sooner or at a faster pace than participants had earlier anticipated. Some participants also noted that it could be appropriate to begin to reduce the size of the Federal Reserve’s balance sheet relatively soon after beginning to raise the federal funds rate. Some participants judged that a less accommodative future stance of policy would likely be warranted and that the Committee should convey a strong commitment to address elevated inflation pressures.” 

In other words, although the Fed publicly committed to tapering (reducing) the pace of asset purchases, it had not publicly said anything about reducing the volume of assets. This new statement, however, suggests that the Fed might consider selling assets such as government bonds and mortgage-backed securities in 2022. Investors were surprised by this and, consequently, sold government bonds and equities following the release. 

Notably, the Fed’s minutes commit the Fed to nothing at all. Rather, the Fed simply signaled that it is thinking about things in a way that investors did not expect. That is not necessarily a bad thing. It helps to anchor investor expectations about Fed policy and about inflation. Moreover, the fact that the Fed is thinking about a faster tightening of monetary policy means that, not only is it cognizant about inflation, it also perceives the economy to be relatively strong. 

Aside from the Fed’s shock to the market, the minutes also provided an indication about Fed leaders’ views on major economic issues. They said that “the path of the economy continued to depend on the course of the virus” and that “new variants” pose a risk. This was written before the current surge in omicron-related infections. Their statement was prescient. 

With respect to inflation, the leaders “pointed to the possibility that structural factors that kept inflation low in the previous decade, such as technological changes, demographics, and the proximity of the ELB in an environment of low equilibrium interest rates, may reemerge when the effects of the pandemic abate.” In addition, the minutes state that “while participants generally continued to anticipate that inflation would decline significantly over the course of 2022 as supply constraints eased, almost all stated that they had revised up their forecasts of inflation for 2022.” In other words, the Fed leadership still expects high inflation to be temporary but expects it to last longer than previously expected. 

US jobs market offers a mixed picture

• Regardless of whether you favor government policies aimed at quelling inflation or policies aimed at boosting growth, you can find evidence to support your point of view in last week’s jobs report. That is, the report offers a mixed bag of sometimes contradictory evidence. On the one hand, the report suggests a very slow rate of job growth in December—much slower than a private sector survey predicted. On the other hand, the report shows the lowest unemployment rate since the pandemic began as well as moderately strong wage growth—both of which are indicative of a tight labor market. Bond yields continued to increase strongly following the report, even as a key measure of inflation remained muted. This suggests that investors expect strong economic growth combined with considerably less Federal Reserve intervention in the bond market. Let’s look at the details:

The US government releases two employment reports: one based on a survey of establishments; the other based on a survey of households. The establishment survey found that only 199,000 new jobs were created in December. Earlier in the week, ADP estimated that there were more than 800,000 new private sector jobs created in December. While the ADP survey and the government report are not always correlated, this gap was quite large. Keep in mind that both reports are based on a survey of a relatively small number of establishments. Surveys sometimes generate results that are not consistent with the larger reality. That could have been the case with one of these surveys. 

In any event, the slowdown in job growth (which predated the surge in omicron-related infections) could reflect the tightness in the job market that was recently revealed in the high number of job vacancies and the persistent weakness in labor force participation. Meanwhile, the number of jobs created in 2021, 6.4 million, was the highest on record. Still, by December the number of existing jobs remained 3.7 million below the prepandemic level of February 2020. Also, one might reasonably assume that, absent the pandemic, the economy would have generated nearly 4 million jobs over the last two years. Thus, it appears that employment in the United States is between 7 and 8 million jobs below the level that would have transpired absent the pandemic. In other words, there remains a long way to go.

The establishment survey also found that the industries that generated the most jobs were leisure and hospitality (up 53,000 in December) and professional and business services (up 43,000). Although employment in leisure and hospitality has grown rapidly in the past year as restaurants and hotels have reopened, the industry still employs 1.2 million fewer people than prior to the pandemic. In professional and business services (our industry), on the other hand, employment is roughly where it was before the pandemic. 

The establishment survey also reports on wage behavior by industry. The survey found that average hourly earnings in December were up 4.7% from a year earlier, lower than the 5.1% clocked in the previous month. This increase is roughly consistent with underlying (core) inflation and suggests that, despite a tight labor market, wages are not accelerating. Nor are wage increases driving inflationary pressure. Yet wage gains varied by industry. For example, average hourly earnings in the leisure and hospitality sector were up 14.1% in December versus a year earlier. In our own professional and business services industry the figure was 6.2%. In manufacturing the figure was 4.4% and in retail trade the figure was 5.4%. 

The separate survey of households says that there were 651,000 more people employed (including the self-employed) in December than in November. The survey found that the participation rate was roughly unchanged from November to December, but still far below the prepandemic level. The unemployment rate fell from 4.2% in November to 3.9% in December, the lowest since the pandemic began. The number of people reporting being unemployed fell by 483,000 from November to December. 

Although job growth was modest in December, it seems likely that the Federal Reserve will stick to its plan to reduce asset purchases and begin interest rate normalization in 2022. I suspect that, rather than focusing on job growth, the Fed is looking at the sharp decline in the unemployment rate, combined with recent data showing a high number of job vacancies. That is, the Fed is likely concerned about the potential inflationary effect of a relatively tight labor market. In fact, today’s sharp rise in bond yields suggests that investors are convinced the Fed will taper quickly and might even start to sell bonds—as suggested in the minutes of the Fed’s December meeting. The yield on the Treasury’s 10-year bond hit 1.78%, the highest since the pandemic began. Of course, keep in mind that, just two years ago, the yield was 2.7%.  

Eurozone inflation continues to rise

• Inflation continued to accelerate in the 19-member Eurozone, with consumer prices up 5% in December versus a year earlier. This was the highest headline inflation since the Eurozone was created two decades ago. Prices were up 0.4% from the previous month. In addition, when volatile food and energy prices are excluded, core prices were up 2.6% in December versus a year earlier, also a record high. Core prices were up 0.4% from the previous month. The difference between the headline and core inflation was mainly due to the 26% annual increase in energy prices. 

By country, annual inflation was 5.7% in Germany, 3.4% in France, 4.2% in Italy, 6.7% in Spain, 6.4% in the Netherlands, 6.5% in Belgium, and 5.7% in Ireland. The unusually high inflation rate in Germany is due, in part, to the reversal of the pandemic-related reduction in the value-added tax (VAT). The increase in the VAT is a one-off event and the impact will gradually fade, thereby reducing inflationary pressure. On the other hand, recent price increases will likely factor in upcoming collective bargaining, thereby boosting wages and possibly contributing to a wage-price spiral. 

Last week’s report indicated an inflation rate higher than what many investors had anticipated. Thus, it raises the question as to whether it will lead the European Central Bank (ECB) to adjust policy. The ECB has already said it will soon halt some asset purchases, but a further tightening seems unlikely. The ECB’s chief economist recently said that the case for higher interest rates “is not there.” The ECB leadership has consistently taken the view that the recent surge in inflation is temporary and that, as supply chains return to normal, inflation is expected to diminish. Recent reductions in shipping costs and increases in industrial output in Asia suggest some improvement in supply chain efficiency.

Deloitte Global Economist Network

The Deloitte Global Economist Network is a diverse group of economists that produce relevant, interesting and thought-provoking content for external and internal audiences. The Network’s industry and economics expertise allows us to bring sophisticated analysis to complex industry-based questions. Publications range from in-depth reports and thought leadership examining critical issues to executive briefs aimed at keeping Deloitte’s top management and partners abreast of topical issues.

Learn more